Make a TFSA A$AP! – Importance of Compound Interest

December 12, 2017

TFSA stands for “Tax Free Savings Account.” A TFSA is an account where “any amount contributed as well as any income earned in the account (for example, investment income and capital gains) is generally tax-free, even when it is withdrawn,” according to the government of Canada. Put simply, when your money grows, and you eventually take it out, you do not need to pay tax on any of it.

Now, for a student this doesn’t seem like a big deal. As students, we often do not make much money, and the little money we do make goes towards tuition. Often we do not even make enough to reach the first tax bracket, and those who do still pay very little tax. So why would we care about not paying tax? After all, we will still need to pay regular income tax like everyone else. Well, you see, when you learn about the wonders of compound interest, you will see how what may now seem like small money, can easily turn into BIG money.

Using the benefits of compound interest is certainly not a “Get Rich Quick” scheme, but it is most definitely a “Get Rich” scheme, and it works without you even doing a thing. Let me explain.

This is the formula for compound interest, and the only thing you need to know about it is that it is exponential with time. This means more time equals more money, and the younger you are, the more money you can make. How much more money you may ask? Well let’s do a little experiment. Let’s pretend someone named Jimmy turns 18 and decides to max out his TFSA, meaning he will put in the annual limit of $5,500 per year. Now, the amount of money Jimmy makes will of course depend on what he decides to invest in with the money in his TFSA. Let pretend he invests in a ETF of the S&P 500 which simply tracks the growth of the 500 biggest American companies. Adjusted for inflation, the S&P 500 has a historic average growth rate of 7% per year. So, this means if Jimmy invests $5,500 at a 7% interest rate, he will make about $130,000 by the time he decides to retire at age 65. I know what you’re thinking. $130,000 is nice, but that’s not rich, you told me I would get rich. You’re right, that’s why every year you need to top up the TFSA. If Jimmy added $5,500 to his TFSA every year, he would have about $2,000,000 by the age of 65. Now those are some nice numbers, and remember, Jimmy didn’t need to move a finger to make those $2,000,000 besides toss as extra $5,500 away every year into his TFSA.

If you follow what Jimmy did and end up with $2,000,000 sitting in a TFSA when you’re 65, you’re still making 7% on that $2,000,000 every year. That’s $140,000!! You’re making a six figure salary by not doing anything at all. Now here’s where the beauty of the TFSA comes in. Most Canadians would need to pay around 30%-40% tax on that $140,000 they made. That’s just over $40,000. You on the other hand get to keep that $40,000 all to yourself. Go buy a boat or something. The point is, you are making a six figure salary by not doing anything, and you aren’t even paying taxes. That my friends, is why you need to start investing in your TFSA A$AP!